International Monetary Systems. Debt Markets

International Monetary Systems Debt Markets The Money and Bond Markets Money market: Market where companies and governments can meet their short-term borrowing needs, and where investors can trade short-term debt instruments. Bond market: Market where companies and governments can meet their long-term borrowing needs, and where investors can trade long-term debt instruments. Why issue bonds?     Diversifying the sources of funding: One of the reasons for businesses and governments to issue bonds is to diversify their sources of funding. Minimising financing costs: A related reason is the possibility of raising more capital at a lower cost. In the case of businesses, bond financing is often less expensive than equity and does not entail giving up ownership or control of the company. Matching revenue and expenses: capital investments such as a copper smelter or a toll bridge take years to complete but are expected to produce revenue over a lengthy period. Bonds offer a way of linking the repayment of borrowings for such projects to anticipated revenue. Controlling risk: The obligation to repay a bond can be tied to a specific subsidiary/project or a specific government agency. This can insulate the parent corporation or government from responsibility if the bond payments are not made as required. Why invest in bonds?   They generally offer lower risk than shares. They are popular among cautious investors because they offer a safe haven against equity risk. Bonds pay a stated amount of income every half-year (or every year) in the form of coupons. Bondholders know the exact date when the bond will be redeemed and the principal repaid. In the case of equities, dividends are unpredictable and  may not be paid regularly. The price at which shares can be sold is also unknown as share price can go up or down. Bond instruments can also help investors such as pension funds to match their liabilities and assets more effectively than equities or other types of assets. Current Yield Yield to Maturity Bond prices and interest rates One of the factors affecting demand for (and the price of) bonds, whether corporate or government, is inflation and interest rates. If the interest rates fall, bond prices will rise. The underlying logic is that investors rush to buy bonds when their yields look attractive compared with the declining rates on bank deposit accounts. The bonds will then rise to a level that reflects the increased demand, and the yields will reduce accordingly until they no longer look attractive. If interest rates rise, bond prices will decline. The duration of a bond measures the sensitivity of the price of a bond to changes in interest rates. Government Bonds They are issued by governments around the world to raise money to finance their budget deficits and investments. • Bonds issued by national governments are called sovereigns, and those issued by sub-national governments, semi-sovereigns. • Investing in UK government’s bonds (‘gilts’) is among the safest forms of lending in the world. They are particularly popular with pension funds. • They are issued by the UK’s Debt Management Office (Treasury) and are traded on the London Stock Exchange. Corporate Bonds They are issued by companies to investors, with the yield depending in part on the credit rating of the company. Investors in corporate bonds face a number of risks. In addition to the inflation/interest rate risks associated with government bonds, they also face credit risk i.e., the likelihood of the bond issuer defaulting on its debt-service obligations. Corporate bonds tend to have more risk of default than government bonds and so tend to pay slightly higher interest. The higher the credit rating the bond issuer has, the less interest the issuer will have to pay. Some corporate bonds trade on stock exchanges, but the vast majority of bond trading occurs in the over-the-counter market. Over-the-counter markets tend to be less regulated, less transparent, and less liquid than stock exchanges. Credit Rating A credit rating is a formal opinion given by a rating agency of a borrower’s ability to service its debt obligations. There are 3 main credit rating agencies that dominate the rating industry  Standard and Poor’s  Moody’s  Fitch All 3 system with the rating credit termed or Aaa), default “D”. Poor’s the scale; its own have an alphabetical where issuers highest credit (or lowest risk) are “triple A” (AAA while those in are termed Standard & and Fitch use same ratings Moody’s uses scale. Different types of Corporate Bonds      Straight bonds: a conventional bond with a fixed periodic coupon payment (e.g., debentures). Adjustable bonds: unlike ordinary bonds, which pay a fixed interest rate over their entire maturity, adjustable bonds have a variable interest rate. Floating-rate bonds have a variable coupon or rate of interest; for example, it may be expressed at 1% above LIBOR (London interbank offered rate) and will fluctuate according to changes in LIBOR. Zero-coupon bonds: they do not pay periodic interest. Instead, they are issued at less than par value and are redeemed at par value, with the difference serving as an interest payment. Convertible bonds: they can be converted into another security, typically the issuer’s ordinary shares. Junk bonds or high-yield bonds: they are classified by credit rating agencies as sub-investment grade, typically BBB (Standard & Poor’s/Fitch) or Baa (Moody’s) International Bonds There are two main types of international bonds: Foreign and Eurobonds. Foreign bonds: bonds issued in the domestic currency of the issuing country but by a foreign entity. Put differently, they are issued outside the issuer’s home country and are denominated in the currency of the country where they are issued.    Bulldogs (sterling bonds); Yankees (US dollar bonds) Samurais (yen bonds); Kangaroos (Australian dollar bonds) Dim Sum bonds (Chinese Renminbi bonds issued in Hong Kong)... Eurobonds: bonds denominated in a currency that is different from the country where the bond is issued. They are subject to less regulation.  Ex: A dollar bond issued in London by a US company. International Money Market The main international money market is known as the Eurocurrency market. Eurocurrency market is defined as banking markets which are conducted outside of the legal jurisdiction of the authorities of the currency that is used for banking transactions. It has two sides to it: the receipt of deposits and the loaning out of those deposits. • Example: dollar deposits held in London. • Example: dollar loans issued in London. The Eurocurrency market provides better deposit and loan rates than those offered by domestic banks located in the country that issues the currency. An important debt instrument traded in the int’l money market is... Euro-commercial paper: Short-term borrowing, usually less than 9 months.